Stock Investing Strategies
What factors should I consider in making investment decisions?
When making investment decisions, really the factors you should consider are driven by your goals. What are you investing for? What are you trying to accomplish? And that's really going to give you the type of investments you can take, which really relates to the risk that you can assume -- the rate of return you're going to need to earn to get to or satisfy that goal. An example of this -- and we can take two extremes -- would be a shorter-term goal. Maybe you need to save for a down-payment on a home. You want to buy a home in five years, stocks might be really inappropriate for you in that period of time because stocks are very volatile in the short term, so maybe you're going to be investing in less volatile investments -- bonds, CDs, something like that. However if you're looking to retire, and you're retiring in 3 years, and the retirement's going to be another 3 or 4 years, then stocks might be very appropriate, as it's a long period of time and they can ride through that up and down market, so you can get a higher return and also be able to take the volatility because you have a longer period of time.
What is the "power of compounding"?
Technically compounding is interest on interest. If your stock interest is realized daily, you're going to get interest on interest at a faster basis and your money will grow quicker. That's really the technical aspect of compounding. When people talk about compounding, often they're really thinking about time; if you started investing at age 25 versus age 35, you'll have so much more money at 65, let's say. The reason for that is really how money grows. If your money doubled every 10 years - which is pretty easy to do - if you started with $1 at 25, by 35 you'd have $2, at 45 you'd have $4, at 55 you'd have $8 and at 65 you'd have $16. However, if you started at 35, you really only have $8, because you have one less double period. Just by starting 10 years earlier, you've actually doubled the amount of money you're going to have at 65. That's just the value of time and how time can really help your money grow. It's a less technical way when many times people are thinking about the power of compounding.
What is "dollar-cost averaging"?
The process of dollar cost averaging is really to get into an investment strategy on a slower basis or over time. So an example of that: if you have $1000 and you are going to invest it in a stock or an equity mutual fund, you could buy all thousand dollars worth of it today or in dollar cost averaging you might average that amount that you go in let's say over a 12-month period where you would put 1/12 of your investment into that strategy over a period of time. The process of doing dollar cost averaging is what it's doing is it's, you are buying in at different prices. So as the volatility of the investment as the investment goes up and down over that period of time, you are buying at different prices and so over the length of your process of buying in you are actually going to get an average price. The theory behind it is you are going to decrease some of the volatility of your purchase price in that investment.
What are the advantages and disadvantages of dollar-cost averaging?
The value of dollar-cost averaging exists if whatever investment you are buying into is going through a down stock market. Dollar-cost averaging means for the same dollars that you are investing you actually are going to be purchasing more shares of that investment. That really is where the benefit comes from. Historically though, when looking at most volatile markets they tend to have more up periods than down periods and so the value of dollar-cost averaging from a historical basis probably really doesn't exist, because you would really end up receiving less shares for the dollars you spend, over the course of the period you are trying to average into that investment.
What is "investing on margin"?
Investing on margin is giving yourself a loan. However, that loan is securitized from your investment portfolio. The best way to think of it is using examples. If you have a $1000 investment, you could loan yourself $500 of that money. Your $1000 is still invested and now you have an extra $500 to do something with. Traditionally, you might buy more securities.
What are the pros and cons of investing on margin?
When it comes to margin investing the pros really have to do with the low interest rate you're going to receive on that loan to yourself. And the reason for that is that its a securitized investment, you have these investments there, so that interest rate is really low. And on top of that you have the ability to deduct margin interest against investment gains, and so the deductibility of that interest makes the effective cost of that loan even lower. That's the real advantage of it. And if you need money in a short term or medium term period of time, you can actually lend yourself money from your securities as opposed to being forced to sell securities which might be a taxable event if you're realizing capital gains in the sale of those investments.The cons have to do with the call provisions that can happen relative to a margin loan. So if you have this margin loan of $500 on a $1000 investment and its all in stocks, and the stock market goes through a really bad period, and your portfolio goes down in value, you have less securitized monies making that loan secure. And the brokerage firm can come back and really want you to pay back that margin loan and you might not have the money to do it.So that "call feature" makes it possible that you can be forced to sell securities in a down market, which generally is not when you want to be a seller.
What is a "call provision"?
A call provision is when a stock brokerage firm that has given you the money says that you need to put more money back into the account or we're going to sell some of your securities to pay off your loan. A call provision happens when your investment goes down in value. What's happening with this margin is they're saying that they'll lend you 5% of the value of your portfolio, but if the value of your portfolio goes down, the amount of money you are being leant would increase as a percentage. You're going to get to a point - maybe 7-8% depending on the security and a lot of other factors - where the stock brokerage firm is going to say that they feel at risk because they don't have enough security on the loan anymore. A call provision is when they state that either they're going to sell some of your securities to pay off the loan, or you need to give them back money.
What is an "option"?
In a traditional sense, or in an equity sense, an option is almost exactly what it sounds like. It's an option to purchase a stock security at a future price. Essentially, you're buying a contract that says in six months, I would like the option to buy this security or commodity at a fixed price. You don't have to execute that option if you don't want to. You'd only do it if the security that you're doing this option on is a greater value than the option you have to purchase it at.
What is the difference between a "trading an option" and a "writing an option"?
Trading options is really the secondary process after an option is written. So somebody writes an option. Someone else makes a purchase of that option. Now there's this contract to buy a certain security at some future date for, let's say, $12. Now the person who owns that option just might not want that option anymore. So he's just going to trade on a secondary market like you would see a stock market. There's actually option exchanges that are going to go through the process of trading those options to other people who want to purchase them at whatever price. The price will change. As you get closer to when that option is going to expire, obviously the price of that option is going to be closer to its actual trading value at that future date.
What is "shorting"?
Short selling or "shorting" is really the process of selling a security that you currently don't own. The concept behind shorting is you believe that the security is going to decrease. What you want to do is sell it for a certain price today assuming that at some time in the future, you can buy it for a lower price to complete the transaction. So in the interim, you need to somehow have that security. You can borrow the security on loan. Lots of time this can be done using the options market. Really shorting is the opposite of being what we call “long” on a stock. It is where you own a security expecting it to grow and you “short” a security when you expect the market to worsen and decrease.
What is "day-trading"?
Day-trading is not really an investment strategy. In fact, with day-trading, you're not really even making a decision that you like the fundamentals of a company. What day-trading is really about is trying to make money on the volatility of an individual security. When you're day trading, you're going to be in and out of whatever you're investing in on a constant basis. You're going to buy it low, you want to sell it high; buy it low, sell it high. As the volatility of an investment changes over time, that's the goal on how you're going to make your money, You want to be out of the market at the end of the day and then you'll get back in the next day. This is where the term "day-trading" comes from.
Is day-trading inherently riskier than other forms of investing?
Speculating is almost always riskier than investing. When you're doing day trading, you don't have a well-defined, prudent investment strategy there to reach some future goal. Day-trading is really more of a get-rich-quick speculative strategy. It's interesting that in the 90s, there was a lot of talk about day trading. We don't hear much of that now, and the reason is that it's played out that people just weren't being that successful long-term as day traders.
